Whole Foods Still Isn't Good Value

hings usually turn nasty when growth stocks stumble, and specialty grocer Whole Foods Market's  latest fourth-quarter results were bad enough to see the stock initially marked down more than 10%. The market obviously believed the company's problems to be industry-wide issues, because sector rival The Fresh Market  was sent down nearly 7% in sympathy. Is the market right to conclude it's an industry issue? And is this a short-term buying opportunity in a long-term growth story?

What went wrong with Whole Foods?
As with all retailers, the key metric to follow is comparable-same-store sales. Unfortunately, Whole Foods managed to miss estimates and reduce guidance for 2014. Its previous outlook was for comparable-same-store sales of 6.5%-8% in 2014, but the weakness in the fourth quarter caused management to lower projections to 5.5%-7%.

Source: company presentations

Moreover, according to management on the conference call:

This change in trends ... ... were seen in both transaction count and basket size and was broad-based across geographies, departments and storage classes.

Why it's a short term issue...
Naturally, analysts were all over the issue during the conference call, but management failed to give a definitive view. In fact, they cited a number of reasons:

• Strategic price-matching initiatives

• Cannibalization of existing Whole Foods stores, with Boston specifically cited

• Weakness in consumer sentiment

• Increased competition

The first three reasons might make you think this is just a temporary dip in fortunes. For example, the pricing initiatives made at the end of the third quarter did affect sales, but according to the company they will drive growth in the long term.

Furthermore, cannibalization is an issue that can be addressed by better selection of new store locations. As for consumer sentiment, this could turn out to be a short-term issue related to fears over the government shutdown, among other factors.

This viewpoint is strengthened when looking at what Starbucks  recently reported on its trading conditions. The coffee shop is always compared to Whole Foods because both companies tend to serve an aspirational clientele. Indeed, the companies have ties because Starbucks is now retailing some of its products in Whole Foods locations. With Starbucks recently reporting 11% growth in the US and its strongest comparable growth in Canada in more than three years, it was reasonable to think that Whole Foods would report good numbers.

...and why it isn't
Foolish investors might like to think this is a merely a blip in the Whole Foods growth story, but there are three reasons why they should be concerned.

First, back on Aug. 28, The Fresh Market only reported 3.4% comparable-same-store sales growth, a figure that is noticeably lower than the mid-point of its long-term target of 3%-5% growth. Another worrying sign was that its new store productivity (the ability of new stores to generate revenue per square foot compared to existing stores) was only 79% in the quarter, where its target range is 80%-90%. Both figures are indications of an increasingly competitive market.

Second, the strategic price-matching initiative was made in order to "address a couple of competitors in particular," according to Whole Foods CEO Walter Robb. Again, this is a sure sign of encroaching competition.

Aside from the other specialty grocers, mainstream grocers like Kroger    have been targeting the organic- and natural-food market. For example, Kroger launched its Simple Truth brand in 2012, and executives are now disclosing that it's close to being a $1 billion brand.

Finally, the Starbucks analogy is not necessarily a good one. While it's true that Starbucks and Whole Foods offer a high level of service and retail satisfaction, there is a key difference between them. Starbucks sells its own branded products, while Whole Foods sells products that can be bought at Kroger or elsewhere. This leaves Whole Foods a lot more susceptible to competition, particularly in a highly competitive category like food. When Starbucks' customers are in the shop, they might not tend to make price comparisons because they can't buy Starbucks products elsewhere.

Where next for Whole Foods?
All told, this doesn't look like a short-term issue for Whole Foods or even for The Fresh Market. On the other hand, investors shouldn't conclude that it's all doom and gloom from here on out. Most retailers would envy Whole Foods' updated forecast of 11%-13% sales growth in 2014, and the secular trend towards healthier and more organic food doesn't seem like it will end anytime soon.

However, the stock simply isn't priced for any sort of future disappointment. Even at a price of $57 per share, the stock still trades at a P/E ratio of more than 33 times forward earnings. Given the downward pressure on its comparable-same-store sales, it doesn't look like a compelling value play.

Is Treehouse Foods Still Good Value?

It has been a difficult couple of years for Treehouse Foods, and the share price is only above what it was back then thanks to the recent strong run. I’m sure that part of this is due to the market’s infatuation with the food sector this year (sparked by Buffett’s move into Heinz), but it is also down to the company successfully reorganizing its activities in line with market shifts.

With some successful acquisitions contributing to revenue growth in the quarter, and more M&A activity to come, its prospects are looking brighter than they have for a while. Is now the time to pick up the stock?

Food for thought

The recent results need to be looked at in depth to ascertain the underlying conditions. On the one hand, revenue was only up 3.1%, and this was largely due to acquisitions. On the other, adjusted EPS rose 17%, and restructuring activities have created a more favorable product mix. Production efficiencies, moderating commodity expenses, and supply chain improvements (transport efficiencies) have helped operating margins.

In a sense, these restructuring efforts were essential because the company has been faced with some difficult conditions in the last few years. Theoretically, a slow consumer environment where trading is down, and promotions and discounting are the key buzzwords, should be ideal for a private label manufacturer like Treehouse.

Unfortunately, it is not that simple. Shifts in consumer spending patterns, and more importantly where they buy certain groceries, has resulted in changing outlooks for some of Treehouse’s customers. Consequently, it has needed to restructure in order to realign its retail channels accordingly. The good news is that some of these changes are now coming to fruition.

There was a $0.14 restructuring charge relating to its soup operations, and if soup is excluded from revenue, then it would have risen a more respectable 7%. The strength comes from growth in its hot beverages (particularly single serve coffee) and from acquisitions in areas like refrigerated dressings and sauces. These are measures initiated to restructure, following some below par performances, with categories like soup and pickles, over the last few years. In addition, the management was pretty clear that more M&A activity is on the cards for 2013.

What to expect this year

Potential investors in Treehouse will have to accept that its prospects are somewhat dependent on the dynamics of the food industry. The industry story of 2013 is likely to be an environment of modest volume growth, aided by moderating commodity input costs. The question is, what will the food companies and grocers do in response? Will they try to hold pricing and take margins, or will they use the opportunity to lower prices and grab volumes or market share?

We got an early taste of these kinds of dynamics with ConAgra’s latest results. Its strategy seems to be to increase marketing activities in the face of weakening volume growth. Of course, this decision is guided by the fact that it tends to have value brands and is already competitive on price. In addition, its acquisition of Ralcorp is a positive indicator for private label manufacturers like ConAgra. In fact, across the retail market, the drive toward private label in-store brands has been a key development in the last few years. ConAgra has a lot on its plate this year, with integrating Ralcorp and dealing with some difficult conditions in the service food industry. Its evaluation of nearly 30 times earnings also suggests there is little room for error in its execution.

Meanwhile, grocers like Kroger have been rolling out corporate brands in order to better compete with lower-priced stores that have been gaining market share. In looking at Kroger’s earnings, I was struck by how tonnage came back strongly when prices abated. This is a sure sign that price sensitivity is still the key determinant of volume growth. The good news for Kroger investors is that margin pressure is finally starting to ease. Commodity prices are moderating for Kroger, and given its sterling efforts to retain market share and footfall with a mix of innovation and pricing, it should now see some margin growth.

A look at Kroger's revenue and margin trends:

Putting these thoughts together, I think it is clear that 2013 will be another year of intense competition categorized by promotions and discounts. As a consequence, the shift to private label brands is unlikely to slow down, and conditions should remain favorable for Treehouse. We are not yet in an environment where customers will take pricing easily.

Where next for Treehouse?

Full year EPS guidance of $3.00-3.10 was maintained, and conditions for Treehouse look better than they have for a few years. The restructuring activities are working, and moderating commodity costs should allow for volume increases, while the trend toward private labels continues. The company appears to have sorted out its retail channel challenges.

The bad news is that, on a forward evaluation of 21 times earnings, the stock is hardly cheap, and I would argue that this sort of company usually needs to be priced at a relative discount to reflect the risk inherent in buying a company whose prospects are largely governed by its customers' trading patterns and decisions.

If you are looking for relative value (in an expensive sector), Treehouse may fit the bill. But, cautious investors may want to wait for a better entry point.

How Much Longer Can Whole Foods Keep Growing?

Whole Foods Market (NASDAQ: WFM) is one of the stocks that is going to give emotional investors sleepless nights. On the one hand it’s starting to look expensive in relation to its growth prospects, particularly with competitors making plans to encroach on its market area. On the other, its growth prospects are starting to make it look cheap on a long term basis. I happen to like both sides of the argument, hence the uncertainty. I don’t buy stocks that I am uncertain of, but I’m sure others will have more concrete views.

I wanted to articulate some of the salient points so investors could make their own minds up.

A Smaller Piece of a Bigger Pie?

The sub-heading is why the proposition is so tricky at Whole Foods. More often than not, any analysis of a company usually involves trying to find its value proposition within a particular point of a cycle that most companies go through.  I’ll try to elucidate. The cycle typically runs a bit like this: high growth nascent industry phase, growth phase as company matures, GDP (plus a bit more) growth phase as maturity sets in and competitors enter, GDP (or less) growth phase as the company matures.

Of course this type of conceptual thinking is usually expressed rationally in a discounted cash flow analysis and the question is always “am I paying the right price for the stock?” The best answer usually lies within a better understanding of where the company is in the cycle. So what does it all mean for Whole Foods?

Well, usually a company is involved in fighting for a bigger piece of a relatively smaller pie in the future. Competitors enter and it gets that much harder to retain or grow market share. However, with Whole Foods I think that its end markets will accelerate in the future so that we will be in an elongated position within the second growth phase of the cycle.  The pie will get bigger and Whole Foods can still generate growth even with a smaller piece.

A quick look at some of the key metrics suggests that quarterly gross margin comparisons are still favorable while same store comparables remain in the 8%+ range.

So far so good, and there are no real signs of slowing growth in the metrics yet.

Bigger Pie

Long term, the trend towards organic, ‘healthy’ or non-GM foods looks assured. I use inverted commas because I’m not someone who views GM foods as being unhealthy, but I am a cynic when it comes to the unfailing ability of the media and celebrities to discuss important subject matters that they know nothing about. Scare stories involving health issues are particularly prevalent and few more so than GM foods.

Another favorable trend will be that of increasing discretionary spending by wealthier career women. I wouldn’t underestimate this trend. Indeed, in the recent conference call Whole Foods outlined that 20% of its customers do about 75-80% of its business. This is a kind of devotion only usually inspired by Scientology or other cults. In addition marketing data suggested that they gained 22% in new customers in the quarter.

In a sense, this is why Wal-Mart (NYSE: WMT) and Costco (NASDAQ: COST) don’t appear to be making inroads yet, despite their expansion into the food category. Shoppers like the Whole Foods retail experience and the feeling of ‘being healthy’ by eating there. They don’t get this at Wal-Mart or Costco, even if the food is exactly the same. Moreover, if Wal-Mart and Costco are expanding their food operations, it will squeeze the traditional mass market grocers who will then try and find other areas of growth, and this could mean trouble for Whole Foods.

A Smaller Piece

With that said, I’m simply not ready to cast aside everything I’ve ever learned about market forces. The big box retailers may not offer the same retail experience to a typical Whole Foods customer, but traditional grocers like Kroger (NYSE: KR) and Safeway (NYSE: SWY) have a footfall of customers who probably also shop at Whole Foods.

Kroger in particular has management that has demonstrated that it is willing to go to every length to wring every sale it possibly can out of its customers. At some point, the sheer weight of footfall will start to tell, and they will both start to grab meaningful market share.

Moreover, while the devoted will still stay, the newly acquired customers may prove fickle amidst the temptation of every food retailer chasing the ‘health’ angle.

Where Next for Whole Foods?

If you strip out the amount spent on new stores the FCF/EV yield is 4.5%, which is a surprisingly high number for such a highly fancied stock. However, I think it does imply that Whole Foods needs to hit its earnings targets over the next few years.

There is little margin for error here, and any slowdown in comparable same store sales growth and this stock will get hit hard. If so, the stock will be worth a look because its end markets look good. However, I would rather buy it when the market is pricing it as I see it, rather than as a bigger piece of a bigger pie.